About Everything: A Perfect Storm of Trends Points to Less Interest In "Things"

Editor's Note: In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses why manufacturers and retailers should prepare for the possibility that “goods” aren’t coming back anytime soon. And, even when (and if) the industrial sector emerges from its long-term atrophy, the underlying framework of the “old economy” will look entirely different than what we see today.

WHAT’S HAPPENING

Worldwide, the goods-producing sector is in trouble.

Ever since the Great Recession, global trade has struggled to keep up with GDP—something it used to beat easily. Over the last two years, the global manufacturing PMI has been steadily sinking.

The U.S. PMI has been under 50.0 for five of the last six months. Globally, both output and new orders are decelerating—for example in China, where manufacturing has been contracting for 13 straight months.

And what about commodity and producer prices? They’ve been tanking. Amazingly, the PPI in just about every major economy has been stuck in deflation since the summer of 2014.

Goods are being lapped by services. The services sector—encompassing activities like media, software, health care, and finance—has posted just one month of contraction over the past two years.

The decline of goods and the rise of services, of course, is a long-term trend that began many decades ago in the high-income world. U.S manufacturing employment peaked in 1979 and has mostly been declining ever since. Yet there was a brief respite following the Great Recession, especially here in the United States. Now, however, the goods sector is once again under assault.

Let’s take a look at some of the new forces that may be driving it down.

WHY IT’S HAPPENING: DRIVERS

The China slowdown

Up until 2014, China’s voracious appetite for more industrial capacity, housing, and infrastructure was propping up raw material prices and goods production worldwide. In its heyday, China was consuming roughly half of the world’s supply of just about every industrial input—from steel and copper to cement trucks and construction cranes. No longer.

Urbanization & Extended Familes

Over the last decade, U.S. rural counties have been depopulating and core urban areas have been growing much faster than historical trend. A rising share of Millennials are ditching their cars, flocking to cities, and starting out their careers in cramped apartments with limited space. More than a quarter of 18- to 34-year-olds live in their parents’ homes and don’t need to buy their own household goods.

Growth of the sharing economy

Old computers and furniture no longer get thrown in the trash, but now enjoy a second life thanks to services like Craigslist and eBay. Platforms like Uber and NeighborGoods allow people to find and use items they want without buying them.

“Experiences” as the new form of conspicuous consumption

In the old days, we bought expensive things to affirm their social status. Nowadays, we can buy expensive experiences and curate them on social media. We can thereby define ourselves more by what we do than by what we own. This trend has taken on new meaning with Millennials, who would much rather go out to dinner or attend a music festival than purchase the latest handbag or golf club.

Digital unicorns

Thanks to monumental advances in IT capabilities and infinite returns to scale, entrepreneurs can now start a profitable company without spending much at all on physical capital (or even on employees). Think Google, Uber, and Amazon. The whole concept of “book value” assets is becoming antiquated.

Demographic change

Aging societies (I’m looking at you, Europe and East Asia) no longer require capital-widening investment. A contracting working-age population no longer needs new factories—or even new houses. Moreover, the retired elderly are the least likely to spend on things and the most likely to spend on services (starting with health care and personal care). What’s more, they receive their benefits from taxes on young people—who historically are the most likely to want to buy things.

BROADER IMPLICATIONS

Falling commodity prices are hammering developing countries. Major players in Latin America and Sub-Saharan Africa have entered a “tailspin.” If this decline is indeed the new normal, poor commodity-exporting countries will have to turn to human capital—like India and the Philippines, which are turning their fluency in English to open up new service opportunities for the working class.

U.S. retailers are updating their playbooks. Companies from Urban Outfitters to REI areturning their stores into “experiences” with fun diversions and top-notch customer service. Others, like Home Depot and Lowe’s, are expanding into new markets (home services, in this case). And e-tailers like eBay and Bonobos are going high-touch with new brick-and-mortar outlets.

The U.S. economy is encountering an imbalance between the buying of private things (which is weakening) and the backlog of demand for public things like infrastructure (which is growing). It was the G.I. Generation’s commitment to building a new public infrastructure in the 1930s, ‘40s, and early ‘50s, which enabled the booming “affluent society” in subsequent decades. America may be ready for a reboot.

TAKEAWAY

Manufacturers and retailers should prepare for the possibility that “goods” aren’t coming back anytime soon. Even when (and if) the industrial sector emerges from its long-term atrophy, the underlying framework of the “old economy” will look entirely different than what we see today.

SECTOR SENTIMENT RUN

Our monthly sentiment run is a behavioral, market-based gauge of investor sentiment in the Basic Materials Sector. Any relative performance measure is tied to the benchmark S&P 500 Materials Sector INDEX (GICS). Further screening methodologies are included in the link to the tracker below.

Looking at short-interest, 5 of the top 12 least shorted names are in the Gold Mining & Chemicals space with large-cap Diversified Metals and Miners being the most heavily shorted (FCX, AA, TCK, AWC, FMG). With the reflation in commodity-leveraged sectors from the February lows, short-interest has declined 2-5% of float in the aforementioned 5 large cap miners. Gold Miners and Trading & Distribution are the least heavily shorted sub-sectors with Commodity Chemicals, Coal, and Aluminum the most heavily shorted.

9 of the top 12 with the lowest buy ratings are in the Metals & Mining space, with 4 of those 9 being Gold Miners. Forest Product companies West Fraser Timber and Canfor Corporation have the highest sell-side “BUY” ratings in the sector. Construction Materials is the other sub-sector with the highest sell-side “BUY” ratings

Combining consensus “buy” ratings and short-interest, Forest Products,Diversified Chemicals, and Specialty Chemicals names have the most positive relative sentiment when combining both metrics. Diversified Metals and Mining, Aluminum, & Steel have the most negative sentiment.

With the move in the precious metals against a depreciating USD YTD, relative outperformance, declines in volatility premiums, and net futures and options positioning all suggest the market views Gold Miners much more favorably vs. the beginning of 2016. Earnings estimates have also been revised higher with little sector short-interest prices as much of gold production and sales in the sector is left unhedged. Looking at gold derivative markets, the market has gone from a consensus net short futures and options position moving into 2016, to a consensus long position in gold (TTM and 3 year z-scores are tracking +2.2 and +2.7 respectively). With that being said bullish price and VWAP momentum and the bullish rate-of-change in contract positioning and open interest have slowed substantially month-over-month.

The market has treated the Fertilizer and Ag. Chemicals relatively poorly over the last year with bearish top-down macro and industry fundamentals weighing on the sector. MOS, POT, CF, and YARA are among the top 12 underperformers relative to the XLB on a 1-mth window. YARA, AGU, and K+S are trading -2.5, -1.9, -1.9 (SIGMA) on a relative basis below the S&P 500 Materials Index on a 6-mth window. YARA, AGU, and CF are trading -2.5, -1.8, -1.8 (SIGMA) on a relative basis below the S&P 500 Materials Index on a 1-Year window.

The largest sector divergences in growth metrics (TOP-LINE, OPERATING, BOTTOM LINE) exist in the mining space. We expect a downward revision in sell-side estimates in the space as many mining company expectations still need to be taken down while some are already discounted. Earnings growth estimates remain depressed in the large cap-diversified Metals & Mining Companies(TCK, VALE, FMG).Gold Miner earnings expectations have been upwardly revised with the YTD move in gold prices while some remain depressed. We attribute any depressed gold miner earnings expectations to a lag in sell-side revisions. 5 of the top 12 names with the highest earnings growth expectations are Gold Miners (EGO, ACA, AEM, GG, AUY).

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04/04/16 10:37 AM EDT

[UNLOCKED] Early Look: The Taming of Profits

Editor's Note: The Early Look below was written by Hedgeye CEO Keith McCullough one week ago. It crystallizes many of our current thoughts about the precarious macro setup and why we think U.S. equities are in trouble. Click here to get it delivered in your inbox weekday mornings.

* * * *

“No profit grows where no pleasure is taken.”

-William Shakespeare

And, generally speaking, no multiple expansion grows when there’s no corporate profit growth. Rather than The Taming of the Shrew (i.e. where that Shakespeare quote comes from), USA is seeing The Taming of Profits.

No, I’m not talking about the taming of US stock market profits and/or returns (i.e. the ones that were negative in 2015 and mostly negative for 2016 YTD) – I’m simply talking about US Corporate Profits, which were reported to have remained in #Recession on Friday.

No worries. We’ll probably be the only ones on Wall St. writing about it this morning. If only the bulls of the 2015 peakwarned you that Q415 corporate profits would slow another -540 basis points sequentially (vs. Q3 when they first went negative) to -10.5% year-over-year.

Back to the Global Macro Grind…

As Darius Dale wrote to our Institutional clients on Friday, you have to go all the way back to the depths of the 2008 Financial Crisis (Q408) to find a worse year-over-year decline in US Corporate Profits.

“More importantly, Q4 marked the 2nd consecutive quarter of declining corporate profit growth… such occurrences have been proceeded by stock market crashes in the subsequent year for at least the past 30 years (5 occurrences).”

Since Q4 ended on December 31st (they haven’t been able to centrally plan a change in the calendar dates yet), has anyone considered why we just saw the worst 6 week start to a stock market year ever? Yep, it’s the Profit vs. Credit Cycle (within the Economic Cycle), stupid.

Ok. If you’re not stupid, but really super smart and still blaming “the algos and risk parity funds” for the AUG-SEP and DEC-FEB US stock market declines, but giving them 0% credit for the JUL, OCT, and MAR decelerating volume bounces… all good, Old Wall broheem, all good.

Many who missed the economic cycle slowing from its peak (and the commensurate profit #slowing and credit cycles that always come along with such a rate of change move) will blame the US Dollar for that.

They, of course, wouldn’t have blamed Ben Bernanke devaluing the US Dollar to a 40 year low for the all-time high in SP500 Earnings (2015) though. That would be as ridiculous as blaming the machines and corporate buy-backs for market up days.

Last week the US Dollar came back, and the “reflation” trade didn’t like that. With the US Dollar Index +1.2% on the week:

The Euro (vs. USD) fell -0.9% on the week to +2.8% YTD

The Yen (vs. USD) fell -1.4% on the week to +6.3% YTD

The Canadian Dollar (vs. USD) fell -2.0% on the week to +4.3% YTD

Commodities (CRB Index) fell -2.4% on the week to -2.3% YTD

Oil (WTI) fell -4.1% on the week to -1.3% YTD

Gold fell -2.5% on the week to +15.3% YTD

Yeah, I know. Those 5 things are just the things that have immediate-term inverse correlations of 79-99% vs. the US Dollar, but there’s this other big thing called the SP500 that now has an immediate-term (3-week) inverse correlation of -0.80 vs. USD too.

Imagine that. Imagine the machines stopped chasing the hope that the Fed fades on their rate hike plan, the US dollar gets devalued (again), and all of America keeps arguing about the “inequality” gap having nothing to do with Fed Dollar Policy?

You see, when you devalue the purchasing power of a human being:

A) Almost everything they need to buy to survive goes up in price as the value of their currency falls

B) A small % of human beings (i.e. us) get paid if they own the asset prices we are “reflating”

And if you’re not a human being (i.e. you’re a US corporation) and your profits are falling, all you have to do is lever the company up with “cheap” US debt, buy back the stock with other people’s money, lower the share count, and pay yourself on non-GAAP earnings per share.

#America

While small/mid cap US Equities reverted to their bear market mean last week (Russell 2000 down -2.0% on the week and -16.7% since US Corporate Profits peaked in Q2 of 2015), so did a few other US Equity Market Style Factors that had had a big 1-month bounce:

At the same time, Consensus Macro positioning remained what most US stock market bulls would have to admit they want/need from here (Down Dollar => Up Gold, Commodities, and Oil):

Net LONG position in USD (CFTC futures/options contracts) was -2.16x standard deviations vs. its TTM average

Net LONG positions in Gold and Oil held 1yr z-scores of +2.45x and +1.33x, respectively

In other words, in the face of both the economy and profits slowing, Wall St. wants to go back to that ole story of Burning The Buck, I guess. It’s sad and it probably won’t work… but, as Shakespeare went on to say about profits and pleasures, “study what you most affect.”

Risk Managed Long Term Investing for Pros

Wavering Fed Faith: Will U.S. Follow (Crashing) Japan & Europe?

Takeaway:The central planning #BeliefSystem is breaking down.

Following the worst U.S. stock market decline to start a year (ever), manic market myopia has set in among investors overweight advice of domestic permabull storytellers. They're missing criticial context in addition to a significant risk developing with respect to wavering faith in the global central bankers.

For the record, outside the recent Fed-stoked rally in U.S. equities, European and Asian markets remain deeply troubled as the central planning #BeliefSystem (in the ECB and BOJ) continues to break down.

"The yen up small +0.2% vs USD was enough to keep the Nikkei from bouncing overnight; Nikkei 225 closed down another -0.3% taking its crash from the July 2015 high to -22.8% and -15.4% YTD (China and Hong Kong closed today)"

Looking at Europe...

"Post a dreadful producer price report of -4.2% y/y for the Eurozone this am the ECB’s Praet is saying they’ll “continue to act forcefully” (to try to tone down Euro Up vs Yellen’s Dollar Down move) so let’s see how European stocks react to this as they were down (again) last week with Italy’s MIB Index -2.1% w/w to -17.0% YTD."

So ... what happens when the Fed (like its central-planning brethren abroad) loses all macro market credibility and the U.S. economy continues to deteriorate? If Europe and Japan are any indication, the outlook isn't good.

Three of the four biggest public Nike distributors have released 10ks to date, and the Nike growth trends (measured by Nike as a % of purchases) have shown signs of a top. The headline, of course, is the deceleration of Nike sales within Foot Locker from 73% to 72% in 2015 (for a more detailed overview of our thoughts see our full note: FL | Nike Found Its Ceiling). But, just as important is the measured Nike growth within HIBB, up 180bps YY vs. 340bps in both 2014 and 2013, and DKS up just 100bps despite a renewed emphasis on footwear and additional floor space allocated to apparel from underperforming categories like hunt and golf. Nothing that any of these retail partners sells drives more traffic and boosts ASP more than something with a Swoosh on it. Unfortunatley for Nike’s partners, incremental Swoosh growth is coming from Nike direct putting an end to the nine year tailwind experienced by the industry.

The critical point to understand when examining these relationships is how Nike accelerated penetration in its wholesale accounts over the past nine years while it built up its distribution network, on-premise manufacturing capability (i.e. you go to a Nike store, build a shoe and it is made before your eyes), and ability to ship single pairs efficiently to consumers rather than a containerload of 5,000 units to wholesalers. We’d argue that Nike funded growth in the DTC platform by way of outsized (and unsustainable) growth at its wholesalers.

So let’s fast-forward to the present… we’d argue that Nike is largely penetrated in virtually all its wholesale doors in the US. We’re seeing higher price points, which is great. But most of those higher-priced shoes are available only at nike.com or Nike’s ‘snkrs’ app. With those two taken in context, is it any surprise that Nike finally said in public that it will massively accelerate its e-commerce from $1bn to $7bn? Not at all. In fact we think that Nike is understating it’s e-comm growth potential over the next 5 years by as much as $4bn.

Perhaps most important in this discussion is that we are seeing a shifting distribution paradigm in NA (from traditional wholesale to Nike DTC) play out in every quarter that Nike reports. Here are the most notable highlights from the most recent Nike quarter…

1) Lower Lows at Wholesale, Higher Highs for DTC. NKE NA biz grew 13% during the 3Q16. The incremental $429mm in revenue was essential evenly split between wholesale and retail, with DTC growing 25% fueled by e-comm, and wholesale up 9% against the easiest comp in the past 5 years (3% wholesale growth in 3Q15). If we look at it on a 2yr basis, eliminating all of the quarterly noise, we’ve seen a meaningful bifurcation in the underlying growth trend – not over the past three quarters, but past three years.

2) Channel Growth Spread at New Peak. The growth spread (calculated by taking DTC growth minus Wholesale growth) accelerated to 16% in 3Q16. The chart itself paints a pretty clear picture on how Nike is turning the distribution paradigm on its head, but what we think is most important to point out is that we are seeing higher highs in the DTC growth rates as the business approaches $4bn in sales. Over the course of the next five years we expect Nike to blow away its $7bn e-commerce target with the majority of that growth coming in its home market. That means an incremental $5bn-$6bn in NA e-commerce off a base of ~$750mm today. That translates to a continued widening in the growth spread over the near and long term.

3) DTC Penetration is Accelerating – Off a Higher Base. DTC Penetration as a % of total sales accelerated meaningfully in the quarter on a TTM basis, up 75bps representing the largest growth rate we’ve ever seen sequentially at Nike NA. To add a little context, over the past five years NKE NA DTC has grown its penetration by 450bps. This one quarter amounted for nearly 20% of that growth. If we look at where Nike direct competes online, its at the top end of the distribution chain. Put another way it’s at the product level which drives ASP and traffic to the likes of Foot Locker, Finish Line, and Dick’s Sporting Goods. As Nike continues to push its DTC agenda, those dollars come directly from that tier of the market, while the mid-tier channel stays more or less isolated.

Takeaway:Yellen's dovishness has driven sentiment back into the green; both our short and intermediate-term measures of risk are now mostly bullish.

Key Takeaway:

The majority of risk measures eased this week in reaction to Fed Chairwoman Yellen's dovish comments on Tuesday. However, not everything is rosy. Two measures of counterparty risk, the TED spread and CDOR-OIS rose; the TED spread jumped by +6 bps while the CDOR-OIS moved up +1 bp. The TED spread is the difference between LIBOR and short-term treasury rates, and the CDOR-OIS is the difference between the Canadian interbank lending rate and overnight indexed swaps. Both measures isolate the risk that banks perceive in lending to each other; the latter measures that risk specifically in Canada.

1. U.S. Financial CDS – With Fed Chairwoman Yellen's indication on Tuesday that the U.S. Federal Reserve would need to proceed with caution due to uncertain global risks, swaps tightened for 14 out of 27 domestic financial institutions, and the median spread tightened by -2 bps from 95 to 93.

3. Asian Financial CDS – Financial swaps in Asia shared in the global tightening on expectations for slow changes to interest rates from the Federal Reserve. The median spread in the region tightened week over week by 9 bps to 127. Even in Japan swaps mostly tightened, while a BoJ survey on Friday showed business confidence at its lowest level in three years; this contrast is one more indication of the sway that Federal Reserve policy holds over global markets.

10. Euribor-OIS Spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread was unchanged at 10 bps.

13. Chinese Non-Performing Loans Chinese non-performing loans amount to 1,274 billion Yuan as of Dec 31, 2015, which is up +51% year-over-year. Given the growing focus on China's debt growth and the potential fallout, we've decided to begin tracking loan quality. Note: this data is only updated quarterly.

14. 2-10 Spread – Last week the 2-10 spread widened to 105 bps, 2 bps wider than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.

15. CDOR-OIS Spread – The CDOR-OIS spread is the Canadian equivalent of the Euribor-OIS spread. It is the difference between the Canadian interbank lending rate and overnight indexed swaps, and it measures bank counterparty risk in Canada. The CDOR-OIS spread widened by 1 bps to 41 bps.

Joshua Steiner, CFA

Jonathan Casteleyn, CFA, CMT

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